Magazine

Fast and Curious: Keeping Forecasts Realistic

By Sallie Krawcheck

October 3, 2016

No one knows what the future looks like. That’s why every good financial advisor from here to Juneau repeats some variation of “past performance isn’t an indicator of future success” when talking about investing. Still, the past can have value when you’re looking to the future.

That may sound like fortune cookie wisdom, but it’s true: observations of past market behavior are useful when you’re trying to see how a portfolio is likely to perform in similar scenarios down the line. And our Stanford-Ph.D-rocking Chief Investment Officer Sylvia Kwan spent hours upon hours — and then some hours more because she’s that committed — figuring out how we can best use these insights at Ellevest.

The result? Realistic. Forecasts.

(By the way, we can actually quantify “realistic” for you. It means we project that you have a 70% likelihood of reaching the goal target we calculate for you — or better. Some of the other digital advisors out there give you higher forecasts that you only have a 50% likelihood of hitting. Just saying.)

Our forecasts are backed by a sophisticated projection engine, hundreds of market simulations, and high standards. But that’s enough telling you how realistic our forecasts are. In this follow-up to the ABCs of the Ellevest investment methodology, we’re getting down to the nitty gritty and showing you exactly what makes our forecasts so realistic:

WFE, FTW.

One of the key building blocks in the Ellevest toolkit is the sophisticated Wealth Forecasting Engine (WFE) from Morningstar Investment Management LLC. The WFE, which we use to forecast how an investment portfolio may perform under different economic scenarios, is just one example of Morningstar’s smarts. This institution has two patents, 10 Graham & Dodd awards (a prestigious award for excellence in financial research and writing), and 35-plus years of experience under its belt.

We’ve integrated the WFE into our investing algorithms to project your possible goal outcomes — basically how your investments are likely to fare in a range of hypothetical markets. And yes, that includes market downturns similar to October 1987 and the 2008 financial crisis, plus other nail-biting moments.

By the way, that “plus…” really matters. Because unlike some other forecasts with models that assume these downmarket scenarios have a 0.13% probability of occurring, our forecasts use models that assume these events actually have a 1% chance of happening — which is pretty close to what we’ve seen in the past. And that’s a big difference. Big. Huge. We factor that higher probability into each of our forecasts, which may make them lower, but also gives you a better sense of how your portfolio may do if another bad October hits.

Our forecasts are backed by a sophisticated projection engine, hundreds of market simulations, and high standards.

But let’s get back to the WFE. The WFE is based upon Monte Carlo simulation, which is less Grace Kelly and more Grace Hopper than it sounds. Monte Carlo simulation is a computer-based analysis that produces a wide range of market scenarios that happen at frequencies we’ve seen in the past. To do this, the WFE takes inflation and other economic elements into account; the returns and risk we may expect from different asset classes; and the range of yields offered by various bonds — aka capital market assumptions — and then builds hundreds of economic scenarios around them.

When You Assume...

Some assumptions — like girls can’t do math as well as boys — are 100% incorrect and backed by zilch.

Other assumptions — like the capital market assumptions we use in the WFE — are backed by Morningstar’s research and serious market and economic analysis. And thanks to those years of market observations, we’re able to create hundreds of scenarios that reflect behavior we’ve seen in the past. Here’s one example: The odds of interest rates shooting up one year and then plummeting the next are super slim (historically, rates have moved slowly), so we wouldn’t create a scenario with yo-yoing rates while building your forecast.

The Ellevest Difference

We’re all about shooting for the moon. Otherwise we wouldn’t be telling you to ask for that raise. Or to invest in your goals to help make them a reality. Or to consider joining us as we break the age-old rules around women and investing.

And we do that by incorporating three very important factors into our forecasts: taxes, your estimated salary growth, and the glide path.

We include the impact of taxes on an annual basis because….um….it’s a real cost: the IRS requires that investors pay taxes on interest income, dividends, and any realized gains. A forecast that doesn’t account for taxes may look bigger, but it’s an incomplete picture. (Remember your shock when you got your first paycheck back in high school and realized that taxes meant you had less money than you expected? And what a let-down that was? We don’t think you should be surprised like that again.)

Your salary growth matters, too, because women’s salaries peak earlier than men’s (ugh), so a forecast that uses a one-size-fits-all salary curve really best fits men. Tale as old as time, amiright? Let’s look at the numbers: Women with bachelor’s degrees can expect their earnings to reach a high near age 40, whereas men with bachelor’s degrees can expect that at around 55. This means many women will see their highest-earning days 20-plus years before they hit full retirement age. Men’s salary-peak-to-retirement waiting period is less than half as long. Really puts the retirement savings crisis into perspective, doesn’t it?

So yeah, a fixed salary growth curve just won’t do when our salaries don’t grow that way. That’s why we use a women-specific, education-based curve for a more realistic perspective on what you’ll likely earn, be able to save, and be able to invest over the years. And if you beat the odds and your salary grows longer than most? All the better because that will give you a greater chance of reaching your goals and more money to invest. But, in our opinion, better to be conservative here.

Then there’s the Ellevest glide path. This describes how we shift the mix of investments in your portfolio the closer you get to your goal date. We do this with the intention of helping you sail smoothly (that’s why it called a “glidepath”) into retirement, your new home, your business — whatever your goal may be.

Some other advisors may use glide paths, too, but their forecasts make it seem like your portfolio will stay the same until your goal date. When they do this, you’re left with an unclear picture of what you can expect by the time your goal date arrives. We think the glide path is pretty important and we do it for your benefit to give you as much clarity as possible.

We take our responsibility to you in our forecasting very seriously. And, as a fiduciary, we are obligated to act in your best interests. So our forecasts may not be as big as some of the the other guys’, but bigger isn’t always better — or realistic. And we feel they beat some of the other guys’ where it counts the most: working to give you a 70% likelihood of reaching your goal target compared to their 50%. Ok, we can’t predict the future, but we work hard to give you a better picture of all you’ll be able to accomplish in it.

Morningstar, Inc. has a minority equity interest in Ellevest. Ellevest has separately engaged Morningstar Investment Management, LLC to provide certain services, including its wealth forecast estimators and consultation regarding the make-up of the portfolios (including specific ETFs included in client portfolios). Ellevest uses Morningstar’s services as it believes that doing so is in the best interests of its clients. Further, Morningstar has no control over Ellevest’s investment decision making process.

Information was obtained from third party sources, which we believe to be reliable but not guaranteed for accuracy or completeness.

The information provided should not be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice.

The information provided does not take into account the specific objectives, financial situation or particular needs of any specific person.

Diversification does not ensure a profit or protect against a loss in a declining market. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

Investing entails risk including the possible loss of principal and there is no assurance that the investment will provide positive performance over any period of time.

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